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Trustees urged to stay calm amid ATO scrutiny of investment strategies

Emma Rapaport  |  13 Sep 2019Text size  Decrease  Increase  |  
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Diversify or face a $4200 fine. That’s the blunt warning from the tax office that has sparked fear among superannuation trustees.

But trustees in the $700 billion self-managed superannuation sector who received the taxman’s angry letter last month over failure to diversifytheir nest egg have been urged to stay calm.

Trustees who have 90 per cent of their retirement funds in a single asset class, such as property or cryptocurrency could face a fine of $4200 from the Australian Taxation Office.

SMSF specialist adviser and director of Verante Financial Planning Liam Shorte said the ATO's letter of warning had sparked panic among many trustees. But he sought to reassure them it was a case of more bark than bite.

"The nature of letters from any government department at the moment see to be focused on grabbing your attention," Shorte told Morningstar.

"So, the threat of a $4200 fine trustees may not have ever known about certainly achieves that aim. We see the same in Centrelink and ATO debt or late lodgement notices.

"However, in most cases after a chat with their accountant or adviser they can review their current SMSF Investment Strategy to ensure that the issues raised by the ATO have been “considered” and risk mitigation measures addressed in updated strategy."

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Late last month, ATO deputy commissioner of taxation James O'Halloran issued letters to about 17,000 SMSF trustees and their auditors warning them they were failing to meet the diversification requirements under the superannuation act.

This equates to about 3 per cent of the nation's almost 600,000 SMSFs.

"Our records indicate that your self-managed super fund investment strategy may hold 90 per cent or more of its funds in one asset, or a single asset class," letters to trustees and auditors said.

Shorte said the ATO is not questioning trustees' rights to have more than 90 per cent of their retirement funds in a single asset but wants to ensure they have considered to pros and cons of that strategy.

"This added attention will ensure that going forward fund trustees make more of an effort to complete a comprehensive investment strategy covering risk, members' needs, asset allocation targets, diversification or reasons and understanding of the risks of lack of diversification, liquidity," he said.

"Having to consider these issues will help focus trustees' minds on their investment decisions and in my opinion may avoid some risky or poorly understood investments."

However, Shorte acknowledged that some trustees – particularly those with high gearing, low liquidity, problem properties, crypto or penny dreadful shares – may not have a viable answer to the ATO's questions, resulting in contravention reports from their auditors and a fine.

Under the act, trustees are required to formulate, review regularly and give effect to an investment strategy that regards the extent to which they are diverse or involve exposure of the entity to risks from inadequate diversification.

The ATO followed up with a warning that trustees are ultimately responsible for ensuring their investment strategy meets the requirements under the law, and that failure to meet the requirements could result in a penalty.

The banking regulator, the Australian Prudential Regulation Authority, is responsible for regulating authorised superannuation funds. The ATO and Australian Securities & Investments Commission are joint regulators of SMSFs.

The ATO administers the relevant super laws for SMSFs, while ASIC regulates financial services to protect consumers and manages SMSF auditor registrations.

The Australian's Robert Gottliebsen expressed frustration with the ATO's approach, saying if it continues to "step into financial planning issues", this could "cause great damage to the nation".

Writing in the Australian Financial Review on Thursday, SMSF Association chief executive John Maroney says this action "immediately raises concerns as to whether the ATO is overstepping its role as regulator".

However, he writes: "as the ATO does not have a prudential supervisory role, [the] letters should not be seen as an attempt by the regulator to limit the ultimate control of investment afforded to SMSFs."

Cash and property: areas of concern

Shorte said the ATO was particularly anxious about trustees who have 100 per cent on their portfolios in property with no liquidity.

"It is events like loss of tenant or a rise in interest rates and expenses that the ATO is really concerned about," he said.

"These people who may have bought in regional areas, mining towns or off-the-plan units may have negative equity and rising costs as rents drop and repair bills rise.

"Some of these investors have been missold property but many just did not do their research and jumped on the property boom bandwagon too late."

The ATO letters come amid a crackdown on SMSF trustees who borrow large sums of money via limited recourse borrowing arrangements to invest in the property market.

The Productivity Commission took aim at SMSF lending in a report last July, saying that while the borrowing is "unlikely to pose a material systemic risk", active monitoring is "clearly warranted to ensure that SMSF borrowing does not have the potential to generate systemic risks in the future."

The Hayne royal commission into banking has also targeted financial advisers who encourage SMSF trustees to invest in property where it is not in their best interests.

Several banks including Westpac (and its subsidiaries), ANZ and NAB have all stopped offering loans to SMSFs for property investments.

It is also those is cash funds which may concern the regulator, Shorte said.

"Some people who have knee-jerk reactions in years where superannuation has poor returns roll their funds to an SMSF without having a plan.

"They discover they do not have enough to borrow for a property or find making the decision to buy shares or other assets daunting and unfortunately the money can stay in cash during years of procrastination."

It's worth noting that some industry and retail super fund allow members to have 100 per cent of their assets in a single asset class like cash.

But Shorte says there are circumstances where trustees have a good reason for being in a single asset class.

Firstly, it is not uncommon for trustees to hold SMSFs in a single sector but also keep an industry or retail super fund to manage shares, ETFs and managed funds.

Others, he says, only believe in bricks and mortar and don't trust their retirement savings in investments outside property.

Then, there are those, mostly small business owners, who have specific strategies such as owning commercial property in the fund for security of tenure and are paying down any loan quickly, which Shorte says can be a good strategy.

"However, I would always recommend clients keep 20-30 per cent in liquid assets even if it is an offset account against the loan or a diversified ETF or share portfolio. You never know when you will have repairs or worse still a flood or fire damage," he says.

Lastly, there are those investors who are solely focused on dividend-paying Australian shares and the franking credits attached.

Time to review your investment strategy

SMSFs have steadily been diversifying away from Australian shares and cash, according to a July survey of the sector by Vanguard/Investment Trends.

'Diversification' was listed as the top priority for advisers when selecting investments for their SMSF clients, and trustees cited ETFs as a key reason for increased diversification, presumable because of their perceived ease of access and diversification advantages.

However, the average trustee still holds 25 per cent of his or her portfolio in cash, even as rates continue to slide to historically low levels.

For trustees who received the ATO letter, Shorte recommends using an investment strategy template to explain their reasoning for their investment choice under each of the headings the ATO has highlighted:

  • diversification or risk of lack of diversification (investing in a range of assets and asset classes)
  • the current and future liquidity needs of the fund’s assets (how easily they can be converted to cash to meet fund expenses)
  • the fund’s ability to pay benefits (when members retire or die) and other costs it incurs
  • the members’ needs and circumstances (for example, their age and retirement needs).

is the editorial manager for Morningstar Australia. Connect with Emma on Twitter @rap_reports. You can email Morningstar's editorial team editorialAU[at]morningstar[dot]com

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